Accounting standards are rarely the stuff of front-page news. But over the past year, the debate over fair-value accounting has jumped from the pages of accounting journals and into the business sections of newspapers nationwide, bringing unprecedented national attention to an issue to which very few outside the accounting profession had ever paid much attention. For a few extraordinary months, some of the nation’s most prominent economic and political commentators, politicians, business leaders, industry and professional associations, and pundits engaged in a high-stakes debate about fair-value accounting and its relationship to the credit crisis, culminating in a closely watched congressional hearing and subsequent issuance of new guidance by the Financial Accounting Standards Board (FASB).

The results of this sometimes-contentious public dialogue have far-reaching implications for corporate directors and the rest of the American business community. At the most basic level, the pronouncement issued by FASB last spring gives enhanced guidance to companies and their external auditors regarding the application of fair value, with a specific emphasis on the use of judgment. Beyond this concrete change, the fair-value debate has also created fresh questions and new public scrutiny around the role of FASB as an independent standard setter.

On the Mark?
The term “fair value” accounting, also known as “mark-to-market,” refers to the practice of using available market information to estimate the price an asset would be worth if it were sold or the cost to settle a liability. The basic principle of using market information to value at least some assets dates back over thirty years. During the last 15 years, FASB has adopted standards that have expanded and refined the application of fair-value accounting, because it has been widely viewed as an important driver of increased transparency. Put simply, applying market information to value assets and liabilities gives investors relevant information about the economic realities of the companies in which they choose to invest.

Blackstone Group Chairman Stephen Schwarzman vigorously campaigned against fair value, calling it “pro-cyclical.”

Investor demand for increased transparency has only grown over the years. The savings and loan failures of the 1980s spurred the wider application of fair-value rules. With the passage of the Sarbanes-Oxley Act of 2002, the audit committees of corporate boards were given a more prominent role in the hiring of external auditors and greater oversight of the audit process, including the application of fair-value accounting. As fair value was increasingly viewed as an important tool for improving investor access to valuable information, there was a perceived lack of a single, consistent definition for the term, or clear guidance for its application. In order to address those concerns, in 2006 FASB promulgated FAS 157. This action by FASB did not “create” fair-value accounting or somehow tighten standards; rather, FAS 157 simply established a uniform definition of what “fair value” means and provided a consistent framework for its continued application.

The introduction of FAS 157 was hardly noticed by those outside the accounting profession. In 2006, when the standard was issued, the capital markets were strong and asset holders were apparently satisfied with the prospect of marking the value of assets to the pricing information provided by markets prevailing at that time. For calendar year-end companies, the new standard would apply to financial statements for the period beginning Jan. 1, 2008, and in 2006 there was no reason to assume that 2008 would pose a problem with respect to market values. But the world was about to change.

The Fair-Value Spiral
By late 2007 and into 2008, the global credit crisis began to take hold. Asset-backed securities, particularly those tied to sub-prime mortgages, began to collapse in value as the housing market softened. Securities that had been considered relatively safe investments were suddenly revealed as highly risky. As the markets for these assets seized up, financial institutions were forced to take substantial write-downs. The write-downs reflected losses in the underlying value of assets that then led to the collapse in the market valuation of these firms, raising concerns about their ability to meet their regulatory capital requirements.
In the face of the growing crisis, the financial industry and others began seeking emergency remedies. Among the various options, attention quickly zeroed in on fair-value accounting. One of the dilemmas critics of the accounting model raised was, what happened when the market became illiquid and pricing information scarce?

In April 2008, Steve Forbes, who would become a leading fair-value opponent, published an opinion piece urging the Bush administration to temporarily suspend mark-to-market accounting. Blackstone Group Chairman Stephen Schwarzman vigorously campaigned against fair value, calling it “pro-cyclical.” Former Federal Deposit Insurance Corporation chairman William Isaac, along with former House Speaker Newt Gingrich, joined this chorus of voices calling for changes to, or suspension of, fair value. Trade associations including the American Bankers Association (ABA), the Independent Community Bankers Association (ICBA), and others stepped into the fray, arguing that fair value is not the most relevant measurement for financial instruments.

On the other side of the issue, proponents of fair value accounting, including the Council of Institutional Investors (CII), the Consumer Federation of America, and the Chartered Financial Analysts (CFA) Institute, as well as the Center for Audit Quality, issued a series of open letters and public statements arguing that fair-value accounting was not the cause of the credit crisis, nor would its suspension resolve it. Rather, these groups argued that fair-value accounting provides investors with critical transparency into the economic realities of public companies. They argued further that undue outside pressure should not be allowed to compromise the independent standard setting process.

The fair-value debate continued to intensify over the fall and into the winter of 2008-2009 as the financial crisis deepened. When Congress approved the Emergency Economic Stabilization Act, creating the Troubled Asset Relief Program (TARP) to protect the solvency of 19 of the nation’s largest financial institutions, it directed the Securities and Exchange Commission to study the issue.

In December, the SEC issued its report, which concluded that fair-value accounting had not caused the credit crisis and argued against suspending or substantially changing the standards. Rather, the report indicated that bank failures in the United States appeared to be the result of growing probable credit losses, asset quality concerns, and, in certain cases, eroding lender and investor confidence. While the SEC was clear in its judgment, the debate continued.